On March 30, the Treasury Inspector General for Tax Administration (“TIGTA”) issued a report entitled “The Growth of the Marijuana Industry Warrants Increased Tax Compliance Efforts and Additional Guidance. We’ve reviewed the report and summarize it as follows:

  • TIGTA ignores the black market in its entirety. There is a high probability that black market sellers do not file tax returns or property apply section 280E. Our view is that Treasury should also be concerned about lost revenue from noncompliance within the black market rather than focus its efforts on state-legal operators.
  • TIGTA relied on statistical sampling to estimate that cannabis companies underreported federal tax liabilities of $48.5 million. TIGTA’s conclusion is based on anticipated section 280E adjustments where they determined there was a “high rate of noncompliance” in Washington, Oregon, and California. Those anticipated adjustments primarily relate to the following three areas:

1. Section 263A adjustments. Prior to the Tax Court decision in Harborside, many cannabis taxpayers took the tax return position that they could rely on the uniform capitalization rules found in section 263A to determine cost of goods sold (“COGS”). Before the Tax Court’s decision, the IRS issued a Chief Counsel Advice memorandum, which discussed the IRS position that cannabis companies could not rely on section 263A to determine COGS. Because the memo was not authoritative, many taxpayers rolled the dice and applied section 263A. We believe that following the Harborside decision, the risk of understating tax liabilities should be materially lower than tax periods occurring prior to it. We previously discussed the conclusion in Harborside and what it meant for cannabis companies here.

2. Section 168(k) adjustments. The so-called Tax Cuts and Jobs Act (“TCJA”) provides most taxpayers with immediate expensing of new and used property used in their trade or businesses under section 168(k). Cannabis companies subject to section 280E are limited to reducing their gross income by any depreciation capitalized into inventory and later reducing gross receipts as COGS.

3. Section 179 adjustments. The immediate expensing available under section 179 is subject to the disallowance provisions of section 280E. It is unlikely that a trafficking business would be entitled to bonus depreciation. Any mention of this on a tax return is likely to face scrutiny upon examination.

  • Taxpayers should review their 2015 – 2017 federal tax returns and determine whether any of the above items are readily identifiable. If they are, taxpayers should consider (1) filing amended tax returns, or (2) be prepared to concede the issue if the returns are examined. Taxpayers may also want to determine the applicable statute of limitations for an IRS examination. There is a risk that the statute of limitations is longer than the default rule of three years.
  • TIGTA notes the tension between access to banking and tax compliance. Many cannabis taxpayers face limited banking options. Taxpayers operating on an all-cash basis are more difficult to audit. Further, the IRS was not regularly comparing data reported on federal tax forms with data reported to state agencies. While the fate of federal banking legislation remains suspect at best, taxpayers should be prepared to reconcile any discrepancies between data reported to state regulators or banks with data reported to the IRS.
  • TIGTA made a number of recommendations to the IRS. The IRS agreed with most of these recommendations. However, the IRS noted multiple times that its activities are dependent upon agency priorities and available resources. The IRS response suggests that they are aware of the perceived problems, but we are unlikely to see any immediate responses. This response is similar to what the industry has seen with respect to federal enforcement in other areas. Those areas include the Controlled Substances Act (see Cole and Sessions memos), and the Food, Drug, and Cosmetics Act, where the FDA has taken limited enforcement action against companies adding CBD to food products. The IRS response feels similar.
  • TIGTA is concerned that cannabis taxpayers will take aggressive section 471(c) tax return positions. TCJA codified an exception to the inventory methodologies described in section 471 regulations for certain taxpayers with less than $25 million in gross receipts. The report states that “IRS Chief Counsel noted that practitioners assert that the new law may provide small business taxpayers wide latitude to characterize all expenditures as [COGS]. The effect of the new law is still uncertain” (emphasis supplied). Taxpayers with “applicable financial statements”—typically those with loan requirements to produce them—are probably stuck relying on an inventory methodology permitted by GAAP. Taxpayers without applicable financial statements will face the temptation to adopt aggressive accounting procedures, which require capitalizing indirect costs into COGS. The IRS appears ready to challenge aggressive positions, but they may face an uphill battle. Section 471(c)(1) eliminates the IRS’s ability to challenge a taxpayer’s method for determining COGS as clearly reflecting income. On the other hand, the IRS is likely to rely heavily on the Tax Court’s discussion of COGS in Harborside. The Tax Court repeatedly states, for purposes of Constitutional limits on taxing gross income, that COGS means gross receipts minus direct costs. We believe there is material risk the IRS will challenge any aggressive section 471(c) position that includes direct and indirect costs in calculating COGS. The IRS will likely argue cannabis taxpayers must calculate COGS by applying the Constitutional definition (direct costs only) and without regard to section 471 or the regulations.

Note: The report does not address or consider the rapid expansion and development of hemp within the U.S. Hemp businesses do not generally face the same tax consequences as cannabis trafficking businesses. However, they do face similar issues, such as access to banking. Because of the risk that some hemp producers could inadvertently produce illegal cannabis rather than hemp, additional guidance from the IRS on when hemp businesses would be considered trafficking and subject to section 280E could be helpful for industry participants and tax practitioners.